Money and Banking

You might be able to teach an entire course on the microeconomics of money and banking based on the following thought experiment.

Imagine the following scenario. I want to start a business, but I need to borrow $10,000 to get started. You offer to provide me with that $10,000. However, since you won’t get to consume using that $10,000 and you won’t get to invest that $10,000 in anything else you require that I pay you some interest. I give you a piece of paper that promises to pay you back, with interest, at some future date in time. Intrinsically, that piece of paper that I have given you is worthless. It is just a piece of paper. However, if that piece of paper represents a legally binding agreement, then we call that piece of paper a bond. You are willing to accept that piece of paper from me because you anticipate that I am going to do something productive with your money. In the event that I don’t, you will be entitled to the assets of my business. So, the value of the bond is the expected value of the bond over the duration of the loan plus the value of the option to seize my assets in the event that I cannot/do not pay you back. Now, of course, there is some chance that between now and when I have promised to pay you back you will want to spend money. As a result, a market emerges that allows you to sell this piece of paper to other people.

Now imagine the following alternative scenario. Suppose that you want to save, but you don’t want to deal with trying to figure out how to invest that savings. Fortunately, we have a mutual friend who likes to do this sort of thing. So you give your $10,000 to our friend and he promises to give you your money back plus some interest payment. I also make a visit to our mutual friend, but I ask him to borrow $10,000. He agrees to lend me $10,000, but I have to pay him back with interest (slightly higher than what he is offering you). Since our mutual friend knows that you might need cash for unexpected expenditures in the future, he promises to give you the right to show up and demand your $10,000 (or some fraction thereof) at any moment you want. Thus, to our mutual friend, the value of the loan is the expected value of the loan over the duration agreed upon plus the expected value of the option to seize my assets in the event that I cannot/do not pay him back. The value of the contract for you is the expected value of the loan that you have given our mutual friend plus the value of the option to get your $10,000 back whenever you want plus the value of the option to seize the assets of our mutual friend in the event that the value of his assets decline below what he owes you.

What is the difference between these two scenarios?

Some would say that in the latter scenario the problem is that our mutual friend is offering to give you dollars that he himself does not have to give. Thus, he is “creating dollars out of thin air.” In fact, if he doesn’t have actual dollars, he might give you a piece of paper that promises to give you those dollars in the future. If you are able to trade these pieces of paper in exchange for goods and services, it would appear as though our mutual friend has really created money out of thin air. But has he really? Or is he merely allowing you to transfer some fraction of what he owes you to another individual?

Why might people be willing to accept these pieces of paper printed by our mutual friend and use them in transactions?

Replace “$10,000” with “7.5 ounces of gold.” Do your answers to these questions change?

Reasoning from Interest Rates

A quick note…

We can think of long-term yields as consisting of two components, the average expected future short-term rate and the term premium. However, it is important to note that the average expected future short-term rate itself is a function of the rate of time preference, expectations of future growth, and expectations of inflation. Also, the term premium is a function of duration risk, a liquidity premium, and a safety premium.

So suppose that you see long-term yields change, what can you learn about the stance of monetary policy?

October Surprises

I recently talked with Jim Tankersley of the Washington Post about October surprises.

What Are Real Business Cycles?

The real business cycle model is often described as the core of modern business cycle research. What this means is that other business cycle models have the RBC model as a special case (i.e. strip away all of the frictions from your model and its an RBC model). The idea that the RBC model is the core of modern business cycle research is somewhat tautological since the RBC model is just a neoclassical model without any frictions. Thus, if we start with a model with frictions and take those frictions away, we have a frictionless model.

The purpose of the original RBC models was not necessarily to argue that these models represented an accurate portrayal of the business cycle, but rather to see how much of the business cycle could be explained without the appeal to frictions. The basic idea is that there could be shocks to tastes and/or technology and that these changes could cause fluctuations in economic activity. Furthermore, since the RBC model was a frictionless model, any such fluctuations would be efficient. This conclusion was important. We typically think of recessions as being inefficient and costly. If this is true, countercyclical policy could be welfare-increasing. However, if the world can be adequately explained by the RBC model, then economic fluctuations represent efficient responses to unexpected changes in tastes and technology. There is no role for countercyclical policy.

There were two critical responses to RBC models. The first criticism was that the model was too simple. The crux of this argument is that if one estimated changes in total factor productivity (TFP; technology in the RBC model) using something like the Solow residual and plugged this into the model, one might be misled into thinking the model had greater predictive power than it did in reality. The basic idea is that the Solow residual is, as the name implies, a residual. Thus, this measure of TFP only captured fluctuations in output that were not explained by changes in labor and capital. Since there are a lot of things besides technology that might effect output other than labor and capital, this might not be a good measure of TFP and might result in attributing a greater percentage of fluctuations to TFP than was true of the actual data generating process.

The second critical response was largely to ridicule and make fun of the model. For example, Franco Modigliani once quipped that RBC-type models were akin to assuming that business cycles were mass outbreaks of laziness. Others would criticize the theory by stating that recessions must be periods of time when society collectively forgets how to use technology. And recently, Paul Romer has suggested that technology shocks be relabeled as phlogiston shocks.

These latter criticisms are certainly witty and no doubt the source of laughter in seminar rooms. Unfortunately, these latter criticisms obscure the more important criticisms. More importantly, however, they represent a misunderstanding of what the RBC model is about. As a result, I would like to provide an interpretation of the RBC model and then discuss more substantive criticisms.

The idea behind the real business cycle model is that fluctuations in aggregate productivity are the cause of economic fluctuations. If all firms are identical, then any decline in aggregate productivity must be a decline in the productivity of all the individual firms. But why would firms become less productive? To me, this seems to be the wrong way to interpret the model. My preferred interpretation is as follows. Suppose that you have a bunch of different firms producing different goods and these firms have different levels of productivity. In this case, an aggregate productivity shock is simply the reallocation from high productivity firms to low productivity firms or vice versa. As long as we think of all markets as being competitive, then the RBC model is just a reduced form version of what I’ve just described. In other words, the RBC model essentially suggests that fluctuations in the economy are driven by the reallocation of inputs between firms with different levels of productivity, but since markets are efficient we don’t need to get into the weeds of this reallocation in the model and can simply focus our attention on a representative firm and aggregate productivity.

I think that my interpretation is important for a couple of reasons. First, it suggests that while “forgetting how to use technology” might get chuckles in the seminar room, it is not particularly useful for thinking about productivity shocks. Second, and more importantly, this interpretation allows for further analysis. For example, how often do we see such reallocation between high productivity firms and low productivity firms? How well do such reallocations line up with business cycles in the data? What are the sources of reallocation? For example, if the reallocation is due to changes in demographics and/or preferences, then these reallocations could be interpreted as efficient responses to structural changes in the economy and be seen as efficient. However, if these reallocations are caused by changes in relative prices due to, say, monetary policy, then the welfare and policy implications are much different.

Thus, to me, rather than denigrate RBC theory, what we should do is try to disaggregate productivity, determine what causes reallocation, and try to assess whether this is an efficient reallocation or should really be considered misallocation. The good news is that economists are already doing this (here and here, for example). Unfortunately, you hear more sneering and name-calling in popular discussions than you do about this interesting and important work.

Finally, I should note that I think one of the reasons that the real business cycle model has been such a point of controversy is that it implies that recessions are efficient responses to fluctuations in productivity and counter-cyclical policy is unnecessary. This notion violates the prior beliefs of a great number of economists. As a result, I think that many of these economists are therefore willing to dismiss RBC out of hand. Nonetheless, while I myself am not inclined to think that recessions are simply efficient responses to taste and technology changes, I do think that this starting point is useful as a thought exercise. Using an RBC model as a starting point to thinking about recessions forces one to think about the potential sources of inefficiencies, how to test the magnitude of such effects, and the appropriate policy response. The better we are able to disaggregate fluctuations in productivity, the more we should be able to learn about fluctuations in aggregate productivity and the more we might be able to learn about the driving forces of recessions.

Forthcoming Publications

Blogging has been a bit light around here. In lieu of a blog post, here are a few papers of mine have recently been accepted for publication that might be of interest to regular readers:

1. “Money, Liquidity, and the Structure of Production” (with Alexander Salter), Journal of Economic Dynamics and Control. This paper is a little bit of Hayek, Hirshleifer, Tobin, and Dixit all rolled into one. Here is the abstract:

We use a model in which media of exchange are essential to examine the role of liquidity and monetary policy on production and investment decisions in which time is an important element. Specifically, we consider the effects of monetary policy on the length of production time and entry and exit decisions for firms. We show that higher rates of inflation cause households to substitute away from money balances and increase the allocation of bonds in their portfolio thereby causing a decline in the real interest rate. The decline in the real interest rate causes the period of production to increase and the productivity thresholds for entry and exit to decline. This implies that when the real interest rate declines, prospective firms are more likely to enter the market and existing firms are more likely to stay in the market. Finally, we present reduced form empirical evidence consistent with the predictions of the model.

2. “An Evaluation of Friedman’s Monetary Instability Hypothesis“, Southern Economic Journal. This paper examines two elements of Milton Friedman’s work within the context of a relatively standard structural model. The first element is the idea that deviations between the money supply and money demand are a significant source of business cycle fluctuations. The second element is the idea that shocks to the money supply are much more empirically significant that shocks to money demand. Here is the abstract:

In this paper, I examine what I call Milton Friedman’s Monetary Instability Hypothesis. Drawing on Friedman’s work, I argue that there are two main components to this view. The first component is the idea that deviations between the public’s demand for money and the supply of money are an important source of economic fluctuations. The second component of this view is that these deviations are primarily caused by fluctuations in the supply of money rather than the demand for money. Each of these components can be tested independently. To do so, I estimate an otherwise standard New Keynesian model, amended to include a money demand function consistent with Friedman’s work and a money growth rule, for a period from 1875-1963. This structural model allows me to separately identify shocks to the money supply and shocks to money demand. I then use variance decompositions to assess the relative importance of shocks to the supply and demand for money. I find that shocks to the monetary base can account for up to 28% of the fluctuations in output whereas money demand shocks can account for less than 1% of such fluctuations. This provides support for Friedman’s view.

3. “Interest Rates and Investment Coordination Failures“, Review of Austrian Economics. This paper examines the role of interest rates in influencing both production time and entry decisions of firms. The paper therefore examines coordination problems similar to those emphasized in the Austrian business cycle theory and the business cycle theory of Fischer Black. I show that in low interest rate environments firms are more likely to preempt the entry of their competitors at lower levels of demand than when interest rates are high. When firms enter simultaneously at these levels of demand, it is a coordination failure. Low interest rates also produce changes in the length of production that are consistent with the ABCT. This provides some support for business cycle theories such as the ABCT, which have been criticized as violating the assumption of rational expectations.

The theory of capital developed by Bohm-Bawerk and Wicksell emphasized the roundabout nature of the production process. The basic insight is that production necessarily involves time. One element of the production process is to determine the period of production, or the length of time from the start of production to its completion. Bohm-Bawerk and Wicksell emphasized the role of the interest rate in determining the period of production. In this paper, I develop an option games model of the decision to invest. Two firms have an opportunity to enter a market, but production takes time. Firms face a two-dimensional decision. Along one dimension, they determine the period of production and the prospective profit therefrom. Along another dimension, they determine whether or not they want to enter the market given the amount of time it will take to start generating revenue from production. Within this option games approach, the period of production can be understood as an endogenous time-to-build and I argue that this framework provides a tool for evaluating the claims of Bohm-Bawerk and Wicksell against the backdrop of competition and uncertainty. I evaluate the period of production decision and the option to enter decision when the real interest rate changes. I show that investment coordination failures are more likely to occur at lower levels of profitability when real interest rates are low. I conclude by discussing the implications of low interest rates for boom-bust investment cycles.

The Fed, Populism, and Related Topics

Jon Hilsenrath has quite the article in The Wall Street Journal, the title of which is “Years of Fed Missteps Fueled Disillusion With the Economy and Washington”. The article criticizes Fed policy, suggests these policy failures are at least partially responsible for the rise in populism in the United States, and presents a rather incoherent view of monetary policy. As one should be able to tell, the article is wide-ranging, so I want to do something different than I do in a typical blog post. I am going to go through the article point-by-point and deconstruct the narrative.

Let’s start with the lede:

Once-revered central bank failed to foresee the crisis and has struggled in its aftermath, fostering the rise of populism and distrust of institutions

There is a lot tied up in this lede. First, has the Federal Reserve ever been a revered institution? According to Hilsenrath’s own survey evidence, in 2003 only 53% of the population rated the Fed as “Good” or “Excellent”. In the midst of the Great Moderation, I would hardly called this revered.

Second, I’ve really grown tired of this argument that economists or policymakers or the Fed “failed to foresee the crisis.” The implicit assumption is that if the crisis had been foreseen, steps could have been taken to prevent it or make it less severe. But, if we accept this assumption, then we would only observe crises when they weren’t foreseen. Yet crises that were prevented would never show up in the data.

Third, to attribute the rise in populism to Federal Reserve policy presumes that the populism is tied to economic factors that the Fed can influence. Sure, if the Fed could have used policy to make real GDP higher today than it had been in the past that might have eased economic concerns. But productivity slowdowns and labor market disruptions caused by trade shocks are not things that the Federal Reserve can correct. To the extent to which these factors are what is driving populism, the Fed only has limited ability to ease such concerns.

But that’s enough about the lede…

So the basis of the article is that Fed policy has been a failure. This policy failure undermined the standing of the institution, created a wave of populism, and caused the Fed to re-think its policies. I’d like to discuss each of these points individually using passages from the article.

Let’s begin by discussing the declining public opinion of the Fed. Hilsenrath shows in his article that the public’s assessment of the Federal Reserve has declined significantly since 2003. He also shows that people have a great deal less confidence in Janet Yellen than Alan Greenspan? What does this tell us? Perhaps the public had an over-inflated view of the Fed to begin with. It certainly reasonable to think that the public had an over-inflated view of Alan Greenspan. It seems to me that there is a simple negative correlation between what they think of the Fed and a moving average of real GDP growth. It is unclear whether there are implications beyond this simple correlation.

Regarding the rise in populism, everyone has their grand theory of Donald Trump and (to a lesser extent) Bernie Sanders. Here’s Hilsenrath:

For anyone seeking to explain one of the most unpredictable political seasons in modern history, with the rise of Donald Trump and Bernie Sanders, a prime suspect is public dismay in institutions guiding the economy and government. The Fed in particular is a case study in how the conventional wisdom of the late 1990s on a wide range of economic issues, including trade, technology and central banking, has since slowly unraveled.

Do Trump and Sanders supporters have lower opinions of the Fed than the population as whole? Who knows? We are not told in the article. Also, has the conventional wisdom been upended? Whose conventional wisdom? Economists? The public?

So the populism and the reduced standing of the Fed appear to be correlations with things that are potentially correlated with Fed policy. Hardly the smoking gun suggested by the lede. So what about the re-thinking that is going on at the Fed?

First, officials missed signs that a more complex financial system had become vulnerable to financial bubbles, and bubbles had become a growing threat in a low-interest-rate world.

Secondly, they were blinded to a long-running slowdown in the growth of worker productivity, or output per hour of labor, which has limited how fast the economy could grow since 2004.

Thirdly, inflation hasn’t responded to the ups and downs of the job market in the way the Fed expected.

These are interesting. Let’s take them point-by-point:

1. Could the Fed have prevented the housing bust and the subsequent financial crisis? It is unclear. But even if they completed missed this, could not policy have responded once these effects became apparent?

2. What does this even mean? If there is a productivity slowdown that explains lower growth, then shouldn’t the Federal Reserve get a pass on the low growth of real GDP over the past several years? Shouldn’t we blame low productivity growth?

3. Who believes in the Phillips Curve as a useful guide for policy?

My criticism of Hilsenrath’s article should not be read as a defense of the Fed’s monetary policy. For example, critics might think I’m being a bit hypocritical since I have argued in my own academic work that the maintenance of stable nominal GDP growth likely contributed to the Great Moderation. The collapse of nominal GDP during the most recent recession would therefore seem to indicate a policy failure on the part of the Fed. However, notice how much different that argument is in comparison to the arguments made by Hilsenrath. The list provided by Hilsenrath suggests that the problems with Fed policy are (1) the Fed isn’t psychic, (2) the Fed didn’t understand that slow growth is not due to their policy, and (3) that the Phillips Curve is dead. Only this third component should factor into a re-think. But for most macroeconomists that re-think began taking place as early as Milton Friedman’s 1968 AEA Presidential Address — if not earlier. More recently, during an informal discussion at a conference, I observed Robert Lucas tell Noah Smith rather directly that “the Phillips Curve is dead” (to no objection) — so the Phillips Curve hardly represents conventional wisdom.

In fact, Hilsenrath’s logic regarding productivity is odd. He writes:

Fed officials, failing to see the persistence of this change [in productivity], have repeatedly overestimated how fast the economy would grow. The Fed has projected faster growth than the economy delivered in 13 of the past 15 years and is on track to do so again this year.

Private economists, too, have been baffled by these developments. But Fed miscalculations have consequences, contributing to start-and-stop policies since the crisis. Officials ended bond-buying programs, thinking the economy was picking up, then restarted them when it didn’t and inflation drifted lower.

There are 3 points that Hilsenrath is making here:

1. Productivity caused growth to slow.

2. The slowdown in productivity caused the Fed to over-forecast real GDP growth.

3. This has resulted in a stop-go policy that has hindered growth.

I’m trying to make sense of how these things fit together. Most economists think of productivity as being completely independent of monetary policy. So if low productivity growth is causing low GDP growth, then this is something that policy cannot correct. However, point 3 suggests that low GDP growth is explained by tight monetary policy. This is somewhat of a contradiction. For example, if the Fed over-forecast GDP growth, then the implication seems to be that if they’d forecast growth perfectly, they would have had more expansionary policy, which could have increased growth. But if growth was low due to low productivity, then a more expansionary monetary policy would have had only a temporary effect on real GDP growth. In fact, during the 1970s, the Federal Reserve consistently over-forecast real GDP. However, in contrast to recent policy, the Fed saw these over-foreasts as a failure of their policies rather than a productivity slowdown and tried to expand monetary policy further. What Athanasios Orphanides’s work has shown is that the big difference between policy in the 1970s and the Volcker-Greenspan era was that policy in the 1970s put much more weight on the output gap. Since the Fed was over-forecasting GDP, this caused the Fed to think they were observing negative output gaps and subsequently conducted expansionary policy. The result was stagflation.

So is Hilsenrath saying he’d prefer that policy be more like the 1970s? One cannot simultaneously argue that growth is low because of low productivity and tight monetary policy. (Even if it is some combination of both, then monetary policy is of second-order importance and that violates Hilsenrath’s thesis.)

In some sense, what is most remarkable is how far the pendulum has swung in 7 years. Back in 2009, very few people argued that tight monetary policy was to blame for the financial crisis or the recession — heck, Scott Sumner started a blog primarily because he didn’t see anyone making the case that tight monetary policy was to blame. Now, in 2016, the Wall Street Journal is now publishing stories that blame the Federal Reserve for all of society’s ills. There is a case to be made that monetary policy played a role in causing the recession and/or in explaining the slow recovery. Unfortunately, this article in the WSJ isn’t it.

On Adam Smith’s Straw Man

One way to interpret Adam Smith’s Wealth of Nations is as a critique of and rebuttal to what he called the “mercantile system” or today what we would call mercantilism. One critique that Smith made in the book is that mercantilists had an incorrect notion of wealth. In Smith’s view, mercantilists confused money and wealth. According to Smith, this misconception led many mercantilists to see trade surpluses as desirable because it was a way to accumulate gold (money) and therefore make the country richer. As it turns out, this is likely a straw man of Smith’s own construction.

I have recently been reading Mercantilism Reimagined and Carl Wennerlind has an interesting chapter on 17th century views on money in England. Here are some highlights:

  • J.D. Gould’s work in the Journal of Economic History suggests that to understand the literature on money and trade during the 1620s, one needs to understand the circumstances in which the writers were writing. He argues that this writing must be understood in the context of a significant downturn in economic activity that was largely blamed on a shortage of money. It is unclear whether this was due to an undervalued sterling or incorrect mint ratios, but a trade surplus was seen as a way to correct this shortage. In other words, these writers were not advocating trade surpluses for their own sake, but rather to replenish the money stock.
  • Smith’s attacks were on these writers of the 1620s, but he either ignored or was ignorant of a literature that emerged in the 1640s and 1650s associated with a group known as the Hartlib circle.
  • Members of this group thought that the expansion of scientific knowledge would lead to permanent expansions in economic activity. This therefore required an expanding money supply to prevent deflation and other problems with insufficient liquidity.
  • At least two writers within the Hartlib circle denied that the value of money came from the commodity itself (recall that gold and silver were money at this time). Wennerlind quotes Sir Cheney Culpeper, for example, as writing that “Money it self is nothing else but a kind of securitie which men receive upon parting with their commodities, as a ground of hope or assurance that they shall be repayed in some other commoditie.”
  • Culpeper advocated for parliament to create a law that would allow a bill of credit to be transferred from one person to another rather than waiting for repayment.
  • Another Hartlibian, William Potter had a much more ambitious proposal that called for tradesmen to set up a firm and print bills that could be borrowed with sufficient collateral. The tradesmen would agree to accept these bills in exchange for their production. At any time, a bill holder could request that it be redeemed. At that point, a bond would be issued that had to be paid by the borrower of the bill within 6 months. Since the bills were backed by collateral, the only threat to the ability to redeem a bill was a sudden decline in the value of the collateral — although Potter argued that insurance companies could be used to insure against such outcomes.
  • Winnerland argues that both the Bank of England and the South Sea Company were the outgrowth of Hartlib ideas about money and credit.

The fundamental point here is that it seems that there was an influential group of individuals writing in the 1640s and 1650s that were either ignored by Adam Smith or that he simply did not know existed. However, the omission is important. One would hardly consider the views of the Hartlibians as mercantilist. This group viewed scientific advancement as the key to economic prosperity, not trade surpluses and/or the accumulation of money. Culpeper, as evidenced by his quote, did not confuse money with wealth. His quote is consistent with a Kiyotaki-Wright model of money. Similarly, Potter clearly viewed credit and collateral as important for trade and prosperity (perhaps too much so, he predicted that under his plan that the English would be 500,000 times wealthier in less than a half of a century — that’s quite the multiplier!).

In short, this raises questions about the prevalence of mercantilist views in the time before Adam Smith. The critique by Smith that previous writers confused money and wealth might simply be a straw man.